They might sound similar at first, but mutual funds and exchange-traded funds have some key differences.
Investors can use a traditional mutual fund or an exchange-traded fund (ETF) to establish a low-cost, well-diversified portfolio of stocks, bonds and other assets. But there are also striking differences that will influence which fund is best for you.
Mutual funds remain the top dog in terms of total assets thanks to their prominence in workplace retirement plans, such as 401(k)s. U.S. equity mutual funds have around $6.7 trillion, compared with $1.7 trillion for ETFs, according to Morningstar. ETFs, meanwhile, are attracting the majority of new investment dollars. In 2017, the inflows for ETFs hit $464 billion, according to data from State Street Global Advisors. Moreover, 87 percent of financial advisers use or recommend ETFs to their clients, according to the 2018 trends in investing survey.
The key is to understand how the relative advantages of ETFs and mutual funds correspond to your priorities as an investor. There is no perfect fund; there are only funds ideal for you.
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- Both mutual funds and ETFs are low in fees, making them low-cost options to build a diversified portfolio.
- Management styles differ between the two (active vs. passive management).
- Mutual funds can expose you to a higher tax bill.
What both mutual funds and ETFs do well
Investors can use mutual funds and ETFs to buy a wide swatch of stocks or bonds without making too large a bet on any one company or sector.
Take the S&P 500. You can buy the entire index, and the gains of the nation’s largest companies that comprise the list, for a minimal amount with either the Schwab S&P 500 (a mutual fund) or SPDR S&P 500 ETF (an exchange-traded fund). You don’t, then, need to make a specific bet on what General Electric or Apple will do over the next year or so. Instead, you can bet on American economic growth.
Both options charge investors extraordinarily low fees. In this case, the mutual fund actually beats the ETF. In fact, you can easily create a fully diversified portfolio with only three mutual funds or ETFs, using solely one or the other.
Active management vs. passive management
There are some differences — philosophical and technical — that you need to consider before picking an investment choice.
Mutual funds generally break down into two categories: actively managed and passive. The latter track an index, like the S&P 500, in an effort to deliver market returns to its customers. These are low-fee and make no ostentatious claims — you will be the market, rather than beat it.
Actively managed funds, on the other hand, employ a person or group of people to pick which stocks, in the case of equity funds, to buy and which to sell and when. These funds hope to beat the market, and they charge higher fees than passive funds.
Some can justify the extra cost. Most, though, cannot. Over a 15-year period, according to the S&P Dow Jones Indices Scorecard, 92.33 percent of active U.S. equity funds that invest in large companies failed to beat their benchmark.
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Commissions stack up
Of course, you can passively track an index with an ETF, too. If you want to take what the market gives you, which option is preferable? It all comes down to how you trade, assuming a mutual fund and ETF charge similar fees.
If you’re planning on using dollar-cost averaging, where you make predictable contributions to a fund, you’re better off going with a mutual fund. That’s because many mutual funds are available with no transaction fees and no sales commissions. ETF customers might have to pay trading commissions, making frequent buying and selling expensive.
That can add up. Assume someone invests $500 on a biweekly basis in both an ETF and a mutual fund. Both investments get 8 percent annual returns, net of their expense ratio. The only difference is that the investor pays an $8 commission biweekly with the ETF.
After 10 years, you would have paid $3,179 more for the ETF.
Sometimes you have to eat the bullet, though. Unlike most mutual funds, ETFs typically don’t have a minimum requirement. So investors can buy only a few shares, which is a positive for an investing novice. Small investors can avoid commissions altogether by seeking out no-commission ETFs.
Do ETFs pay dividends?
Dividends, or payouts to shareholders, are paid out by ETFs on a quarterly basis. The payout depends on the percentage of shares an investor owns in the fund. Some dividends, however, do not pay dividends. For example, fixed income ETFs pay interest instead.
There are two types of dividends issued to ETF investors: qualified and non-qualified dividends. The difference between the two depends on how they are taxed, and how long the stock within the ETF is held:
- Qualified dividends are paid on stock held by the ETF. The share must be owned for more than 60 days during a 121-day period that begins 60 days before the ex-dividend date, according to Fidelity. Qualified dividends are taxed at the capital gains tax rate.
- Non-qualified dividends are taxed at ordinary income rates.
Watch out for taxes
Mutual funds can expose you to a higher tax bill. Even if the mutual fund isn’t trading a bunch of stocks as part of its strategy, the act of simply redeeming shares for outgoing investors can force managers to sell shares of the investments in the fund.
Any taxes incurred from the sale are paid by shareholders at the end of the year. Even if you buy the fund late in the year, you could still be paying a tax bill for events that happened before you made the investment, thanks to what are known as embedded gains.
But don’t let taxes be the determining factor in your decision. You’re looking for a long-term investment at a low-cost.
The right answer, then, is to pick a set of funds that align with your risk tolerance, give you broad exposure to companies around the world and don’t charge all that much. If you get that down, you’ll do fine.
Which is better for the long term?
Marc Dizard, investment regional manager at PNC Wealth Management, says he wouldn’t classify the two funds as “better or worse.”
“Given the large universe of options in both categories, the answer is really, “It depends,’” Dizard says. “It goes back to the investor’s objectives.”
Dizard recommends investors take a look at how the two differ, and from there decide what is best for their own personal situation. He adds that a well-constructed portfolio often includes both forms of investing to accomplish an investor’s objectives.
Which one is safer?
Determining which form of stocks is “safer” depends on an investor’s individual goals and what they’re comfortable with. As with any investment, the market is bound to fluctuate; times of volatility will occur no matter what your portfolio looks like.
“Each should be evaluated on its own merits with the underlying assets determining which is a “safer” investment,” Dizard says. “An investor in either of these vehicles should evaluate the fund’s prospectus or talk to an adviser to determine if its mandate fits what they are looking for from an investment.”
Other factors that Dizard recommends investors evaluate include: management structure and tenure, fees and expenses, previous results and compliance.
Pros and cons: ETFs and mutual funds
Here are the benefits and drawbacks of exchange-traded funds.
Pros and cons of ETFs
- Lower tax bill with qualified dividends.
- Lower investment minimums.
- Intraday pricing, meaning prices fluctuate throughout the day.
- Charge for commission, making frequent buying and selling expensive.
- Can’t make automatic investments or withdrawals.
Here are the benefits and drawbacks of mutual funds.
Pros and cons of mutual funds
- One price each day after the close of the market.
- Automatic investments and withdrawals.
- Not as tax-efficient as ETFs.
- Usually have a flat dollar amount for minimum investments.